May 4, 2014

One of the most common misunderstandings in pension fund land is that an individual (member) investment policy weighs up to a collective investment approach.

Is there a rule of thumb that expresses 'longevity risk' in terms of the yearly return?

1. Collective vs. Individual Investing Approach

In case of a 'healthy pension fund', new members will join as time continues. In a mature pension fund the balance of contributions, investment returns, paid pensions and costs will stabilize over time.

Therefore the duration of the obligations of a pension fund will more or less stabilize as well. The duration of an average pension fund varies often between 15 and 25 years. Long enough to define a long term investment strategy based on a mix of risky equities (e.g. 60%) and fixed income (e.g. 40%). Regardless of age or status, all members of a pension fund profit from this balanced investment approach.

In case of an individual (member) investment strategy, the risk profile of the individual investments has to be reduced as the retirement date comes near. In practice this implies that 'equities' are reduced in favor of 'fixed income' after a certain age. As the age of a pension member progresses, the duration of the individual liabilities also decreases, with an expected downfall in return as a consequence.

Let's compare three different types of investment strategies to get a clear picture of what is happening:

Now lets compare the pension outcomes of these three different investment strategies with help of the Pension Excel Calculator on basis of the next assumptions:

- Retirement age: 65 year

- Start ages 20 and 40

- 3% and 0% indexed contributions and benefits

- Life Table NL Men 2012 (NL=Netherlands)

Results Pension Calculations (yearly paid pension):

Conclusion I

From the above table we can conclude that switching from a collective investment approach to an individual investment approach will decrease pension benefits with roughly 10%. Think twice before you do so!

2. Longevity Risk Impact

To get an idea of the longevity impact on the pension outcomes, yearly paid pensions are calculated for different forecasted Dutch life tables (Men).

Life Tables

Forecast Life Table 2062 is calculated on basis of a publication of the Royal Dutch Actuarial Association.

The Forecast Life Table 2112 is (non-official; non scientific) calculated on basis of the assumption that for every age the decrease in mortality rate over the period 2062-2112 is the same as over the period 2012-2062.

Pension Outcomes per Life Table

Here are the yearly pension outcomes on basis of the forecasted life tables:

From the above table, we may conclude that the order of magnitude effect of longevity over a fifty to seventy year period is that pensions will have to be cut roughly by 25%-30%.

Another way of looking at this longevity risk, is to try to fund the future increase in life expectation from the annual returns.

The next table shows the required return to fund the longevity impact for different forecasted life tables:

Roughly speaking, the expected long-term longevity effects take about 0.7%-1.2% of the yearly return on the long run.

Finally

Instead of developing a high tech approach, this blog intended to give you some practical insights in the order of magnitude effects of life-cycle investments and longevity impact on pension plans in general.

Actuarial ModelsCollective (organizing) mechanisms are important stuff for actuaries. For example, they play an essential role with regard to all kind of solidarity aspects in pension- and insurance-contracts.

Moreover, collective rational or even emotional behavior often plays a decisive role in our society, as may be clear from the 2009 credit crisis turmoil and the escalating bonus madness.

Be aware, study "collective behavior mechanisms" and take them into account when you set up your actuarial risk model.

Disclaimer

Maggid is an actuarial professional, and like every actuarial professional or human being, he makes mistakes. Maggid encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong.

Nothing written here, or in my writings at Actuary-Info is an invitation to undertake whatsoever action, in particular to buy or sell any particular security; at most, Maggid is handing out educated guesses as to what the markets may do. Maggid thinks that "The markets always find a new way to make a fool out of you", and so he encourages caution with every action, in particular in investing. Risk control wins the game in the long run, not bold moves.

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